Blowing Our own Trumpet

CESR has just published their Technical Advice on the MiFID Review - so I'll probably have something to say once I've digested the 162 pages. But in the meantime, here is the text of the Press Release we issued this morning.

Turquoise number one MTF dark pool for second month running

• July dark volumes show Turquoise extending lead ahead of competitors
• Lit pool also showing steady growth – now 2nd largest MTF for majority of stocks listed
  

Turquoise’s pan-European mid-point book looks set to remain the largest MTF dark pool for the second month running, extending its lead over its nearest competitor during July as the number of active participants continued to grow. According to statistics from Thomson Reuters, it is the only dark MTF to have exceeded €4 billion of traded value in Stoxx600 Europe constituents for the month to date, and is on track to beat its record performance in June despite lower overall market volumes during July.

David Lester, CEO of Turquoise, said:

“We are grateful for the support of our clients in driving the success of our mid-point book. Clients are responding to the growing pool of liquidity and expressing their support for our functionality roadmap which will offer participants greater control and choice when trading in our dark pool. ”

Turquoise has also seen steady growth in its lit pan-European order books, especially pronounced in mid and small cap segments where it has become the second largest MTF for the significant majority of stocks.

David Lester added:

“With growing and diverse liquidity in both our order books, we have positive momentum leading up to the launch of our new trading platform. Given the number of clients and prospects actively testing the new system, we expect the growth to continue once we switch over to Millennium Exchange in October.”

Chart - Mid-point Book Consideration Traded by Month

A Change is Gonna Come...

It would seem that we now have a European equivalent of the SEC’s far-reaching Concept Release. Kay Swinburne’s draft report on MiFID, submitted to the European Parliament’s Committee on Economic and Monetary Affairs, is wide-ranging and ambitious.

The following highlights grabbed my attention;

With regard to Dark MTFs & BCNs, the report

• Explicitly acknowledges that BCNs are different to dark MTFs in that they are an extension of the ‘traditional, discretionary broker-client relationship’.
• Calls for BCNs to disclose to regulators the details of orders matched in the system (which is a significant volume of data), as well as information on the trading methodology, level of broker discretion, and methods of access.
• Calls for an investigation into whether there should be a volume threshold above which BCNs must convert into MTFs.
• Calls for an investigation into setting a minimum order size on BCNs and MTFs as a way of encouraging greater flow of trade to lit venues in the interests of price discovery. And, calls for a review to consider whether such a minimum size threshold be applied to the Reference Price waiver upon which dark midpoint MTFs are reliant (but which does not currently apply to BCNs).
• Calls for a consultation on whether market-making within BCNs should be permitted, or whether they should be restricted to the crossing of ‘buy side customer orders’.
• Calls for a review to consider reducing the current Large in Scale thresholds, and also to broaden the Reference Price waiver to allow matching anywhere in the spread (which could be intended to allow the waiver, including a potential minimum size threshold, to be applied to BCNs also).

With regard to HFT, Co-location and Sponsored Access, the report

• Blames the US May 6th ‘flash crash’ on the withdrawal of HFT liquidity, and suggests a study into whether ‘informal market makers’ receiving a ‘maker’ rebate should have formal liquidity provision obligations and supervision.
• Calls for HFT firms to be regulated to ensure they have robust risk controls in place, and for market operators to stress-test their systems and introduce volatility interrupts and circuit breakers so as to avoid a European ‘flash-crash’.
• Calls for an investigation into the true impact/contribution of HFT trading on other market users, particularly institutional investors.
• Calls for unregulated proprietary trading firms to execute into markets through regulated firms (currently, MiFID allows these firms to join exchanges and MTFs directly).
• Calls for ‘unfiltered sponsored access’ to be expressly prohibited and for the Commission to adopt IOSCO’s principles on sponsored access, relating to the contractual arrangements and respective responsibilities for risk controls & filters – including an obligation for the sponsoring firm to have ‘pre-trade filters’ in place (although it doesn’t address the role of MTFs/exchanges in implementing pre-trade filters on behalf of the sponsor).
• Calls for trading venues providing co-location themselves, or indirectly via third parties, to ensure their co-location arrangements provide equal latency to all co-located customers (which could drive an interesting intrusion by market operators into the commercial affairs of independent data-centre operators).

With regard to market data, the report

• Calls for CESR to clarify and tighten post-trade reporting standards to ensure greater consistency so as to better facilitate data consolidation.
• Calls for venues to unbundle pre and post-trade data so that post-trade data can be acquired (and consolidated) more cheaply.
• Calls for the establishment of a working group to ‘overcome the barriers’ to a European Consolidated Tape and establish a privately run system (without any taxpayer funding).
  

And on other miscellaneous topics, the report

• Calls for all ‘equity like’ instruments including ETFs and DRs to be captured in the scope of MiFID.
• Supports the extension of MiFID to derivative instruments
• Requests that the Council consider extending the MiFID per & post-trade transparency requirements to all non-equity instruments subject to significant secondary trading (including an explicit mention of government and corporate bonds, though no mention of FX).
• Suggests that regulators must have sufficient data to be able to ‘re-create the order book’ – so as to understand the market dynamic and participants’ involvement (similar to the SEC’s $4billion proposal for a ‘Consolidated Audit Trail’ to gather attributed (identifying the underlying end-client) order & trade data across all market venues).
• Suggests that ‘flash orders’ that undermine the equal treatment of all exchange/MTF customers be banned (although it is not clear whether the routing services offered by Chi-x and BATS, and delivered via relationships with selected market participants, are intended to be captured by this).
  

A great deal of thought (and I suspect lobbying) has gone into this report, and the challenges now will be;

• To prioritise amongst the many recommendations to identify those that best promote competition and safeguard the efficiency and integrity of our markets, and to determine how much can be done and how quickly.
• To conduct the multiple investigations, consultations and reviews in an efficient and transparent fashion, ensuring that all the relevant parties have sufficient opportunity to contribute.
• To address the many inter-related issues in a holistic manner, without unintentionally advantaging or disadvantaging different categories of market participant through the uneven introduction of new rules.
  

I’ll return to many of these topics in future posts (although they will likely be every few weeks going forward).

Trade At

In its ‘Concept Release’ published earlier this year, the SEC asked for feedback on a ‘Trade At’ rule. Given that we don’t even have an EBBO or ‘Trade Through’ rule in Europe (indeed, I’ve previously argued against introducing either), you might assume that this idea would have no applicability to our markets – but it is an interesting (and contentious) topic. I decided to blog on this after reading a couple of related posts (titled ‘Recipe for a Toxic Market’) on TabbForum.

The current US Trade-Through Rule principally applies to market centres – and essentially stops any market from trading outside of the NBBO. So if a marketable order cannot be filled at the NBBO in a particular market, the market must either reject the order or onward-route it to a market that can satisfy it at the NBBO. The whole ‘Flash Order’ debate in the US was about market operators trying to avoid returning or routing orders to their competitors (as the rule requires) by instead introducing a brief delay during which it would seek to match these orders against selected liquidity partners.

Some interpreted the SEC’s ‘Trade At’ proposal to imply a tightening of the Trade Through rule, effectively enforcing time-priority across the competing lit venues. This could have the same effect as mandating a virtual Central Limit Order Book (CLOB), possibly undermining competition.

But the real thrust of the debate appears to be whether the ‘Trade At’ rule should apply to non-displayed order matching, including broker internalisation. What exactly does this mean?
The proposed ‘Trade At’ rule is that, when non-displayed orders are matched, brokers and market operators should be required to price-improve on the BBO by a minimum amount - either a full price-tick or a minimum proportion of the spread. In other words, they cannot ‘Trade At’ the BBO price without trading with the best publicly displayed Bid or Offer – effectively giving priority to the participant prepared to display their limit order.

Where displayed markets include non-displayed orders they effectively have a Trade At rule, in that displayed orders typically take priority over non displayed orders to give an execution priority of price, display type. For a non-displayed order to execute, it must be a minimum price increment better than the best displayed price. The same is also true of midpoint (dark) books operated by MTFs under the reference price waiver – they never give a non-displayed order priority over a displayed order at the same price.

Brokers internalise client flow whenever they can – whether they use an (American) ATS or a (European) BCN/BCS or SI as the platform. This makes economic sense both for the broker and for the clients – the broker avoids the exchange and clearing fees associated with trading in a Public Limit Order Book (PLOB), and the clients interact with natural liquidity without signalling their intentions publicly. Often, though not always, the trade will happen inside the spread, offering both clients price improvement versus what they might have achieved in the public market. The more a broker internalises, the more competitive its commission rates for clients can be.

Those market operators accustomed to concentration rules might argue that internalisation shouldn’t be permitted. But it’s also hard to make a principled argument as to why a broker should be forced to buy services from an exchange/MTF and CCP if those services are not actually needed (which is the case if the broker has two clients willing to trade with one another). Especially where the level of post-trade transparency is adequate, it’s not clear who benefits (other than the exchange and CCP) from forcing brokers to use services they don’t need. And if the trade is being executed inside the spread, then there are not, by definition, any other market participants who are advertising their willingness to interact with either the buyer or the seller at that price.

On the other hand, many internalised transactions (especially of retail orders in US markets) happen at (or very close to) the public BBO. This raises two interesting questions;

1. If brokers commit capital to internalise flow at the BBO whenever it is attractive to them to do so, what can be said about the flow that they don’t internalise?
   • Some argue that such non-internalised exhaust flow is ‘more informed’, and hence makes the PLOBs less attractive for posting limit orders than they would be if the flow reaching them was ‘more balanced’.
   • Is there a point at which, when internalisation reaches a certain threshold, the mix of marketable flow reaching PLOBs becomes less attractive, leading to wider spreads?
2. When internalisation happens at the BBO, is this fair to the participant bidding/offering at the BBO in a lit PLOB?
   • Firms post their bids & offers publicly, releasing information which may impact the price, in return for a greater certainty of trading. If the stock can trade repeatedly at your advertised price, but you don’t get filled, does this undermine the incentive to post displayed limit orders in the first place?

Of course, certainty of trade has already been undermined by having multiple competing markets (each with its own queue) – but at least in this case competition is between participants prepared to display their quotes publicly.

So there is a rational economic argument that internalisation of retail flow at the BBO will ultimately lead to wider spreads, (though proving that it’s actually happening would be rather tricky).

Proponents of a Trade At rule argue that this would continue to allow unimpeded matching of client flow within the spread, whilst driving more market-making activity (where the broker buys at the Bid or sells at the Offer) into the public markets. Greater marketable flow reaching the public markets would strengthen incentives for others to post displayed limit orders – driving tighter public spreads.

Firms that prefer to see more liquidity transact in public limit order books (exchanges, MTFs, prop-traders, brokers without the scale to internalise) therefore should be expected to support a Trade At rule. Unsurprisingly, this is indeed the case, although the politics of advocating something that’s potentially unpopular with your largest customers means that the contribution to the debate from exchanges and MTFs is somewhat subdued.

Still, collectivism isn’t a popular concept in capital markets – so arguing that brokers should consume and pay for services that they don’t need because “it’s in the public good” is contentious. And rightly so – legislating a revenue stream is hardly a recipe for competitive behaviour. Indeed, some might characterise it as a form of ‘concentration rule’ – albeit one that doesn’t mandate a single CLOB.

So how do you balance the legitimate (at least as far as I’m concerned) right of brokers to internalise client flow with the public good ensuring PLOB’s remain attractive places to display limit orders?

• You could quite reasonably take the view retail brokers are perfectly equipped to decide what is best for them and their clients – whether that is routing to an exchange or trading OTC against a broker that (through internalisation) offers lower (or zero) commissions.
• You could also argue sensibly that, absent any evidence that spreads are actually widening, there are insufficient grounds to consider such a significant change in regulation.
• If, however, regulators were serious about pursuing a Trade At rule, then one would want either
  • A manageable way to exempt brokers from the requirement to interact with the public markets if they’re already contributing publicly to the BBO price at which they want to trade (because in such a scenario, it is harder to argue that the internalisation has undermined the incentive to post a limit order publicly), OR
  • Alternatively, if an exemption-based approach was impossible to monitor effectively, another solution could be for regulators to mandate a Trade At rule without exemptions, but leave it to market operators to offer reduced cost (and non-cleared) ‘own firm preferencing’ within their order books such that brokers could ‘outsource’ their internalisation.

As I said, contentious. What do institutional investors think?

Distortionary Investing

I’ve been catching up on some academic literature from some respected finance professionals (call me sad if you like, but you’re the one reading about somebody else who reads academic literature)…

Apparently, there is a group of market participants that don’t care about the true value of the companies they trade. They buy or sell without doing any analysis of fundamentals underpinning stock prices. They pay no attention to news of information flow. And they’re prone to exacerbating market trends (amplifying volatility). Left unchecked, these rogue participants will undermine efficient price formation to the detriment of all market participants, and ultimately weaken capital formation in the real economy.

Maybe you think I’m talking (again) about high frequency traders (I know, I’ve being doing so a lot recently, but there’s just so much being said on the topic that I don’t believe to be true). Actually, I’m talking about the buyside – and more specifically, index managers and momentum managers.

To quote a 2005 paper titled “Momentum and index investing: Implications for market efficiency” by Professor Ron Bird and colleagues;

• “The future outlook for market efficiency looks bleak. Arguably, index and momentum investors together represent a large segment of the investor universe, and both are responsible for pricing inefficiency. Perhaps policymakers can do something at the margins to induce more fundamental investing by lowering barriers to arbitrage. We, however, remain pessimistic, distortionary investing seems to have taken on a momentum of its own.”

Of course, fears that passive management would take over the world (often made by active fundamental-based managers trying to sustain higher fees) proved to be a little overblown. Predictions about a supposed threshold for indexed assets (as a % of overall market cap) beyond which price formation would break down proved groundless.

Why did I dismiss these arguments at the time?

• Firstly, I was never convinced that fundamental investors had a common view of ‘fair price/value’ – so even in a world of only active managers, it didn’t seem controversial to suggest we’d still see price swings in response to trading volumes. And if that weren’t the case, then there would likely be insufficient volumes to allow investors to enter/exit positions.
• Next, even if indexers or momentum investors were driving prices away from fair value, to me this seemed essential to creating opportunities for (supposedly) smarter value and contrarian investors/traders to provide liquidity at the margins. I figured that active managers should have seen (supposedly) dumb indexers and momentum investors as the sucker at the table.
• And lastly, at least with respect to index investors, it seemed odd to suggest, irrespective of the proportion of total assets indexed, that they could seriously impact price formation given their buy & hold (forever) strategy. Prices move in response to supply and demand, and if they don’t trade (except when stocks enter/exit the index), then they don’t influence price formation.

So is today’s debate simply history repeating itself? It’s certainly not that straightforward, but the comparison is amusing.

• Indexers invest, but don’t trade, whilst some HFT firms (who end the day flat) trade, but don’t invest. So indexers don’t really influence supply or demand at all, whist HFT firms influence supply and demand equally across the course of the day.


• I’m yet to see any solid statistical evidence that HFT firms exacerbate intra-day volatility. Equally, comparing the Spanish market (where competitive trading remains a pipe dream) to others in Europe, Cheuvreux recently reported (in their Navigating Liquidity paper, appended as annex here) that they found no evidence of HFT firms reducing intra-day volatility. This suggests to me that there is a balance between momentum-based HFT strategies (that amplify volatility) and reversion strategies (that dampen volatility). In other words, to the extent that HFT firms are amplifying volatility, there are institutional brokers and other HFTs developing trading strategies that exploit this.


• And despite the shrill nature of complaints about HFT in the blogosphere, most buyside firms and brokers I talk to are more sanguine. They recognise the improvements to market efficiency that competition amongst markets has delivered, and they fully understand lower trading costs have lead to a growth in high frequency strategies. They’re prepared to work with their brokers to evolve their trading strategies to cope with the new market context. The most thoughtful and informed article on the topic I’ve read of late is here on Institutional Investor.

In the highly competitive exchange/MTF environment in which we find ourselves in (both in the US and in Europe), it’s probably fair to say that, just as lower frictional costs have helped the growth of HFT volumes, so the growth of volumes from HFT firms have been an important factor in allowing markets to lower their tariffs. Any substantial reduction in volumes could force an increase in tariffs, with the danger of kicking off a vicious circle of lower volumes and higher costs – impacting brokers and investors alike. I think that would be a bad trade – although I’m prepared to listen to (coherent) arguments to the contrary.

As ever, I welcome your feedback.

P.S.

• Turquoise was the largest non-display midpoint MTF during the month of June, surpassing Chi-x for the first time. Thank you to those of you who helped us achieve this milestone. Our integrated (displayed) order book volumes are also increasingly often ahead of BATS in certain segments – particularly mid-cap indices such as the MDAX and FTSE250.
• We have now confirmed the timing of our migration to the Millennium Exchange trading platform. Please see the market announcement OP/271/10 under the ‘Operational’ section.